Purpose of Form 5472
In transactions between unrelated third parties, the prices charged between the parties is controlled by market forces. However, with transactions between related parties, there is no corresponding conflict of interest between the parties to ensure that market prices are used. The IRS developed Form 5472 to collect information and identify potential tax issues with regards to transactions between a U.S. corporation and related foreign shareholder. The IRS is focused on the prices charged on intercompany transactions to make sure taxable income is not being shifted offshore by using non market prices. The nature and amount of the related party or reportable transactions must be disclosed on Form 5472. The IRS uses the Form 5472 to assess the materiality and type of the transaction and make sure the pricing used reflects true market pricing.
With inbound U.S real estate investments, the focal point for transfer pricing is the interest rate charged on the loan from the foreign parent to the U.S. blocker corporation. This is because the interest rate has the potential to be overstated to shift taxable income offshore to avoid US income tax. Assuming an interest payment to the offshore related party is exempt under the portfolio interest exemption or taxed at a lower rate under a tax treaty, every dollar of interest paid offshore results in a dollar of income never being taxed in the US or taxed at a lower rate. In turn when the interest is reported by the foreign shareholder to its home country, the interest income may be subject to a much lower tax rate than in the US or may not be taxed at all. The ability to legally reduce the overall worldwide income tax by arbitrarily shifting income between a domestic and a foreign related party is the tax planning strategy the IRS is trying to address by requiring the filing of the Form 5472.
A reportable transaction is any transaction in which there is a perceived potential to shift income. In order for income to be shifted, two things must be present. First the parties must be related and second there must be a transaction between the parties where an income/expense is incurred. Once both of these are present, there is a potential for abuse in the prices charged between the companies and Form 5472 is required.
The potential for manipulation of intercompany pricing only exists in related party situations. While it’s clear that a blocker owned 100% by a single foreign entity is controlled by the foreign shareholder, the net is cast much wider than this. A related party is one who has a significant degree of influence or control over the blocker corporation. For Form 5472 purposes, the ownership threshold is only 25%. A related party is a foreign person who owns directly or indirectly 25% of either the total voting power of all classes of stock entitled to vote or the total value of all classes of stock of the corporation. When there are multiple entities owning the blocker, it is important to understand who the ultimate owners are. (The rules for determining indirect ownership are complex and beyond the scope of this article.) Since the ownership threshold is set at only 25%, there can be more than one related party for a blocker corporation. If two or more foreign persons each own 25% or more of the blocker corporation, then a Form 5472 must be filed for each of the 25% foreign shareholders.
Income and Expense Items
Any time monetary consideration is paid (or accrued by an accrual basis taxpayer) by the blocker corporation to a related foreign shareholder, such as payments for interest, management fees, commissions and amounts borrowed, a potential reportable transaction occurs. As previously stated, the material area where transfer pricing issues occur in an US inbound real estate investment relates to the interest paid or accrued on the loans to the blocker corporation from the related foreign parent. (Since dividends do not reduce a blocker corporation’s taxable income, the payment of dividends is not treated as a reportable transaction as there is no potential for tax avoidance). The amount of interest disclosed must be the amount paid or accrued regardless of whether it was fully deductible on the return. The disclosure on Form 5472 of the amount of the intercompany loan and the related amount of interest provides the IRS with information used to select companies it wishes to audit and to help determine if the transfer pricing is reasonable.
Filing Requirements and Penalties for Noncompliance
In any year a blocker corporation has a reportable transaction with a 25% foreign shareholder, Form 5472 is required to be filed with a timely corporate return for the year in question. A separate form must be filed for each 25% foreign shareholder. If the blocker corporation is owned by four separate 25% foreign corporate parents each with a reportable transaction, a separate Form 5472 would be required for each foreign parent. The penalty for noncompliance is $10,000 for each Form 5472 not timely filed. In the case where there were four separate 25% foreign corporate parents, there would be a total of $40,000 (4 x $10,000) in penalties due if the Forms 5472 were not timely filed. In addition, if the failure to file Form 5472 continues for more than 90 days after notification by the IRS, an additional penalty of $10,000 per Form 5472 will apply.
An additional $10,000 penalty continues to accrue, for each 30day period (or fraction thereof) during which such failure continues after the expiration of the 90day period.
The IRS has also become very aggressive in asserting the Form 5472 penalty. The IRS has adopted a policy of penalizing taxpayers for not filing or filling out forms improperly even if they have paid 100% of their tax due. Ten years ago, paying 100% of tax owed was essentially all that was required of a taxpayer. As part of this shift in paradigm the IRS has programed its computer to automatically assess the $10,000 penalty on any late 5472. In addition to being more aggressive in asserting the penalties, the IRS has become more stringent in terms of what qualifies to have the penalties abated after they have been assessed. An innocent mistake that a taxpayer catches and corrects voluntarily is insufficient for abatement. Filing complete and accurate returns for ten consecutive years will not get the penalty abated for one mistake. Paying all tax due on a timely basis does not get the penalty abated.
Planning and Documentation
The burden of filing the Form 5472 lands squarely on the blocker’s shoulders. The rules in determining if you have a foreign related party are complex and it is important to carefully review your structure to determine if you have any filing requirements for a Form 5472. By far the best time to address the issues is at the time the transaction is being entered and the tax compliance should be integrated into the overall planning process. The transfer pricing rationale and the relationship between the parties should be well documented before the transaction is consummated. After the transaction is completed, the terms of the loan provisions should be closely followed, and proper records and documentation need to be maintained. If these procedures are followed, it will minimize the risk of an IRS audit adjustment or an unnecessary penalty.
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